Arbitrage Opportunities

Arbitrage is the profiting from differences in price when the same security trades on two or more markets.

Arbitrage Spread Betting - It is risk-free, we have Goliath

With an increasing number of financial spread betting companies quoting prices, opportunities arise from time to time for arbitraging between them. Arbitraging involves exploiting the difference in asset pricing between two spread betting companies.

Essentially what arbitragers do is to make a risk-free profit at the expense of the spread betting bookmaker; and for this reason spread bookies are not fond of arbitragers (arbitrageurs in english).

A spread betting arbitrage consists of making an up-bet with one bookmaker, and a down-bet with anothor – the gap in between is the arb’s profit. What these traders do is to buy the spread at one company, and sell it at another for a higher price.

“If the top end of the spread quoted by one company lies below the bottom end of the spread quoted by another, there is potential for arbitrage, in the sense of a riskless profit.”

EXAMPLE OF AN “ARB”

A spread betting company (‘A’) is quoting a spread of 200 – 205 for the closing price of NOD Electronics on its first day of trading on the stock market.

Bookie ‘B’ however is more cautious about the price NOD Electronics will fetch, and is quoting a spread of 177-182.

Jack the Arb grabs his phone and makes a £50 a point spread “up bet” with ‘B’ from 182, and a £50 a point spread “down bet” with A from 200.

Wherever the price of NOD Electronics will move in the days to come, Jack is guaranteed a profit of £900.

Case Scenario 1

Suppose NOD Electronics closes at 195 on its first day of trading.

First bet with spread betting bookie ‘A’ – returns £250 [(200 – 195)*£50]

Second bet with spread betting bookie ‘B’- returns £650 [(195-182)*£50]

Total Profit = £900

Case Scenario 2:

Suppose NOD Electronics closes at 215 on its first day of trading.

First bet with spread betting bookie ‘A’ – loses £750 [(200-215)*£50]

Second bet with spread betting bookie ‘B’ – returns £1650(215-182)*£50]

Net Total Profit = £900

Arbitraging involves profiting from the difference in bid-offer spreads between differ two spread betting companies. One of the notable differences between conventional share dealing and spread betting is that with financial spread trading, you do not actually buy or sell the underlying shares. Instead, you are simply speculating that their price will rise or fall, with the spread betting provider acting as a kind of financial bookmaker. Now, since bookies set their own quotes, this can lead to one quoting a more favourable bid-offer price than another for the same product. This is because while the price quoted on spread betting sites do mirror the real movements in the underlying market, they are not always exactly identical. This provides ‘arbitrage opportunities’ where traders can pocket the difference by buying one quote and selling the other. Interestingly, if you can pull off an arbitrage spread bet, then there is no risk of loss. You’re making money at the expense of the spread betting companies, so you can expect them to be less than happy, but there’s nothing illegal about it.

Online trading has made it easier to compare quotes from different providers although arbitrage opportunities are few and far between. Most spread betting involves the underlying market which gives a baseline for the spread betting companies to create their prices, and you are unlikely to find much variation. Bear in mind that you need to make up the spread before you start to profit, so you are looking for price ranges from two different companies that do not overlap in any way.

Naturally, spread betting providers are keen to prevent this from happening, so they keep a keen eye on the quotes of other spread betting brokers, and are quick to correct their prices in the event of arbitrages. Successful arbitrage requires you to be signed up at several different spread betting providers and to move quickly, as differences usually do not last for long. Finance houses have computers programmed to look for minute differences between markets in the financial securities they trade and act instantly to make arbitrage profits. And they tend to use vast amounts of money to capitalize fully on a small pricing discrepancy. This sort of arbitrage is not for the fainthearted, and probably not viable for the individual trader. But the principles still apply.

Arbitrage Explained

If you cannot understand the workings of arbitrage and how you can get a risk-free profit, here’s a couple of examples to explain how it works. For instance, let’s suppose one spread betting provider is offering a buy price for Vodafone of 122p and a sell price of 117p (117-122), and another firm is quoting Vodafone for a buy price of 112p and a sell price of 107p (107-112). Since the sell price with the first spread betting firm is higher than the buy price with the other, you can secure a gain as long as you place a ‘sell’ spreadbet with the higher priced firm and a ‘buy’ spreadbet with the lower priced provider. In a nutshell, if you can buy at 112p and sell at 117p, you will be guaranteed a profit. So, if Vodafone were to rise in value, you would lose your sell bet and win your buy bet, and the gains from the buy bet would offset the loss from the sell bet. Similarly, if Vodafone were to fall in value, your sell bet would net you more than you would lose with the buy bet, due to the price differential. Obviously, this is an extreme example and price differentials are likely to be much less in practice, but it serves to illustrate the point.

Practical Example

Say you’re looking at the price of JKL Excavation on two different spread betting sites, and notice a discrepancy in the quotes. Dealer 1 is quoting a spread of 315 to 320, and dealer 2 has it priced at 325 to 328. This is an arbitrage opportunity.

All you have to do is make a bet at 320 with dealer 1 that the shares will go up, and another spread bet with dealer 2 that it will go down below 325. Say you bet £100 per point with each. You really don’t mind where the price goes; you have just guaranteed yourself a £500 risk-free profit.

Say JKL Excavation goes up to 350. That’s 30 points, so you win £3000 from dealer 1. Against that, you lost your bet with dealer 2 to the tune of 25 points, which means you lost £2500. Overall, you have made £500 profit. But if JKL Excavation goes down, you don’t mind either. Say it hits 312. That means you lose eight points to dealer 1, and lose £800. But your bet with dealer 2 wins, and you make 13 points times £100, which is £1300. Again, you come out £500 ahead. If you can do it, this is risk free. However, if you place one spread bet, and the price from the other provider is corrected before you place the bet with them, you would be left with a net long or short position.

In practice, spread betting arbitrage opportunities are relatively rare. Most bets involve an underlying market and so all licensed financial spread bookmakers will try to make sure that their spreads reflect prices in that underlying market. Their spreads are thus likely to be very similar and arbitraging opportunities will only exist for a very short period of time..

This means that an arb has to have an eagle eye, and be very sharp. The other anti-arbitrage action that bookmakers may take is to limit the size of bets that they allow known spread betting arbitragers to make. One also has to keep in mind that here you are also competing with automated trading robots that spot and trade the arbitrage almost instantaneously.

Naturally, you won’t often get an opportunity to make a profit like this and you have to keep a sharp eye out for price differentials. The brokers tend to keep their numbers in line, and modern Internet and networking make it much easier for them to do so. However, it is not illegal to take advantage of an arbitrage, and you will not suffer any penalties for doing so. If you’re involved in spread betting on something which is not as clear-cut as a share price, you may find more opportunity for arbitrage. Perhaps you’ll spot a discrepancy and arbitrage chance when looking at the quote for an out of hours security, as these can sometimes drift without any active trading. The price is set by spread betting company on the basis of what they think the next day’s opening will be.

Most arbitrage opportunities open up on spread bets which are not based on an underlying market price, or that are based on an underlying market that is not open at the time. Examples of this include ‘grey-market’ share bets, and out-of-hours bets on the international financial indices. It pays to be on the watch-out 🙂

In both cases, bookmakers have to use their judgement about what the underlying market price will be when the market opens – and these judgements sometimes differ. On the other hand, spread bookies tend to watch each other spread carefully and when a gap does open up, they usually try to close it up as quickly as possible.

Obviously while the lack of opportunity hardly makes this a viable regular income generator, it does happen from time to time and it’s worth keeping a watch out for the occasional arbitrage prospect, and knowing what to do if you see one. Guaranteed profits are not exactly what one calls an everyday experience!

Note: Someone mentioned arbing equity quotes sourced by a provider. Capital Spreads for instance pools its liquidity feed from both the Chi-X and the LSE (for UK equities) and as both these exchanges will transact huge algorithmic trading across them it is very unlikely that the prices on one will be ‘outside’ the price on the other. This means that the price on the Capital Spreads site for UK shares MUST be ‘around’ the real market. i.e with the provider’s spread above and below the best price from either the London Stock Exchange or the Chi-X. Otherwise, they could be ‘arbed’.

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